IN IRS VICTORY, FARHY DECISION REVERSED

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In Irs Victory, Farhy Decision Reversed

 

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A court has upended an earlier win for taxpayers in the case of an owner of foreign companies failing to file required returns. The Internal Revenue Service could have it easier now when levying penalties in similar tax cases.

 

Last year the U.S. Tax Court, in Farhy v. Commissioner, clearly distinguished between a penalty that the IRS is authorized to issue and one that it isn’t without a lengthier legal process. The decision was hailed as a victory for taxpayers who have overseas interests and face additional tax filing requirements.

 

Last month, that Tax Court decision was reversed by the Washington, D.C., Circuit Court of Appeals, a win for the IRS and a potential green light for easier enforcement in future cases similar to Farhy.

 

Background

For tax years 2003 through 2010, Alon Farhy owned 100% of Katumba Capital Inc., a foreign corporation incorporated in Belize. For tax years 2005 through 2010, Farhy also completely owned Morningstar Ventures Inc., a foreign corporation likewise incorporated in Belize. Farhy was required under Section 6038(a) to report his ownership interests in both companies, as taxpayers must usually file Internal Revenue Service Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” to disclose interest or ownership in a foreign corporation. Failure to do incurs penalties starting at $10,000 per form per year.

 

Farhy illegally schemed to reduce the amount of income tax that he owed during these tax years and, in February 2012, signed an affidavit describing his role in that scheme. He was granted immunity in a non-prosecution agreement.

Four years later, the IRS notified Farhy of his failure to file the 5471s; the Tax Court subsequently acknowledged that Farhy’s failure to file was willful and not due to reasonable cause. In 2018, the IRS assessed an initial penalty (under Internal Revenue Code Sec. 6038(b)) of $10,000 for each year at issue and continuation penalties totaling $50,000 per year. Soon after, the IRS levied to collect the penalties.

 

A reversal

Farhy challenged whether the IRS had authority to assess Sec. 6038 penalties, arguing that no law gives the IRS authority to assess penalties under Sec. 6038(b) and that while the U.S. may be able to collect liabilities for these penalties through a civil action the IRS can’t assess or administratively collect these penalties.

Last year, the United States Tax Court agreed, ruling that the IRS lacked the authority to assess and issue penalties directly for failing to file certain foreign tax information. Though penalties could still be issued for failure to file, this decision would have added significant administrative hurdles to get a penalty issued by the IRS court, including having to pursue civil action with the Department of Justice via a lawsuit in federal court. The IRS, as expected, appealed.

Farhy moved to the U.S. Court of Appeals for the District of Columbia Circuit, where initial arguments sparred over nuances of language in the applicable statutes. Seeming to support Farhy and similar taxpayers was a report from the National Taxpayer Advocate that said IRS treatment of IRC 6038 and 6038A foreign information reporting penalties were “legally unsupportable” and “administratively problematic.”

But the case hinged, one observer noted, on simply whether the IRS could assess a penalty for failure to file a required form or ask the U.S. Department of Justice sue and obtain a judgment from a federal district court before it can enforce the penalty?

In May, the Circuit Court’s three-judge panel unanimously reversed the U.S. Tax Court’s earlier decision in Farhy.

“[Farhy] contends that the IRS lacks statutory authority for its decades long practice of assessing and administratively collecting section 6038(b) penalties. As he reads the statute, the government must sue him in federal district court to collect what he owes under section 6038(b),” the Circuit Court’s decision read. “The only question on appeal is what mechanism Congress authorized for the Secretary of the Treasury to collect the fixed-dollar penalties.”

The Circuit court concluded, “based on the statute’s text, structure, and function, that penalties imposed under section 6038(b), like the related penalties under section 6038(c), are assessable. This conclusion is buttressed by more than forty years of congressional acquiescence to the IRS’s practice of assessing section 6038(b) penalties.

“Congress can make a penalty assessable by implication, and it did so here.”

 

Fallout

Farhy may appeal to the U.S. Supreme Court but his case, a matter of procedural authority, could now impact penalties for various forms involving overseas businesses: the 5471; Form 5472, which reports related party transactions; Form 8938 for foreign financial assets; and Form 926, which reports property contributions to foreign corporations.

For all of these, the IRS – at least for the moment – has full authority to assess penalties.

Your tax specialist needs to stay on top of this and many other issues of wealth, foreign income and tax enforcement. If we can help, please let us know.

 

 

About the Author 

Alicea Castellanos is the CEO and Founder of Global Taxes LLC. Alicea provides personalized U.S. tax advisory and compliance services to high-net-worth families and their advisors.

 

Alicea has more than 20 years of experience. Prior to forming Global Taxes, Alicea founded and oversaw operations at a boutique tax firm, worked at a prestigious global law firm and CPA firm.

Alicea specializes in U.S. tax planning and compliance for non-U.S. families with global wealth and asset protection structures which include non-U.S. trusts, estates and foundations that have a U.S. connection.

 

Alicea also specializes in foreign investment in U.S. real estate property, and other U.S. assets, pre-immigration tax planning, U.S. expatriation matters, U.S. persons in receipt of foreign gifts and inheritances, foreign accounts and assets compliance, offshore voluntary disclosures/tax amnesties, FATCA registration, and foreign companies wanting to do business in the U.S.

 

Alicea is fluent in Spanish and has a working knowledge of Portuguese.

 

Alicea is an active member of the Society of Trusts & Estates Practitioners (STEP), the New York State Society of Certified Public Accountants (NYSSCPAs), the American Institute of Certified Public Accountants (AICPA), the International Fiscal Association (IFA), a member of Clarkson Hyde Global, a world-wide association of accountants, auditors, tax specialists and business advisors and the Global Referral Network (GRN).

 

Distinctly, in 2020, Alicea was awarded with a prestigious NYSSCPA Forty Under 40 Award. She was selected as someone that has notable skills and is visibly making a difference in the accounting profession.

 

In 2021 and 2022, Alicea was the Gold and Silver Winner, respectively, of Citywealth’s Powerwomen Awards in the category USA – Woman of the Year – Business Growth (Boutique). In 2023, she continued her winning streak by receiving the Gold award for Company of the Year Female Leadership (Boutique) and the Silver award for Accountancy Firm of the Year at the Magic Circle Awards. Furthermore, Alicea has consistently secured her position in the Global Elite Directory for four consecutive years, being recognized as a Private Client Global Elite Advisor and is currently listed for 2024 as a Non-Legal Adviser. This exclusive directory annually highlights the world’s elite lawyers and outstanding wealth advisors serving ultra-high net-worth clients.

Please note: This content is intended for informational purposes only and is not a replacement for professional accounting or tax preparatory services. Consult your own accounting, tax, and legal professionals for advice related to your individual situation. Any copy or reproduction of our presentation is expressly prohibited. Any names or situations have been made up for illustrative purposes — any similarities found in real life are purely coincidental.